Capital Gains

Alastair Watson, founding partner, FHW Capital

Registered Providers (RPs) of social housing historically sourced their corporate debt finance facilities from a relatively small group of banks and building societies. Prior to the global financial crisis, many of those RPs were able to obtain long-term finance at rates as low as 20-30 basis points (bps) over Libor.

A combination of factors including significant increases in banks’ own cost of funds, higher capital and liquidity requirements, and penalties for maturity mismatching, have caused many of these lenders to withdraw from the business of long-term lending and margins have increased dramatically to 1-2% over Libor. Institutional investors have been attracted into the sector by the credit strength of RPs, which are closely regulated and assumed to benefit from strong government support.

Consequently, the sector has seen a shift towards the capital markets with the social housing regulator – the Homes and Communities Agency – reporting that in 2012/13, bond issues totalling £3.8bn contributed 70% of new financing to RPs. It appears that the approach taken to financing social housing PFIs is mirroring this shift.

The latest of these transactions to reach financial close, the Salford Pendleton Social Housing PFI, is a case in point. The project first came to market in November 2008, with a preferred bidder selected in March 2012. Despite the procurement having overcome multiple hurdles (including insolvency of one of the construction contractors bidding for the project and a review of central government funding for the scheme), in February 2013 the Treasury required the project to secure alternative long-term financing in order to improve value for money.

The consortium sponsor, Together Housing Group, looked at various financing options before selecting a novel two-tranche, fixed rate listed private placement bond solution in April 2013. This approach featured a ‘B’ note (comprising circa 13% of the debt raised) that provides credit enhancement to the ‘A’ note by creating a first loss ‘cushion’ and boosts the debt service cover ratio of 1.25x on the underlying debt to 1.50x on the ‘A’ note. Both the ‘A’ note and the ‘B’ note were listed on the Irish Stock Exchange.

The FHW Capital team was responsible for structuring the finance and was able to deliver fixed pricing commitments from private placement investors (a fixed spread of 190bps over gilts for the ‘A‘ note and a fixed coupon of 8.35% for the ‘B’ note) for a period of over three months. Another key benefit of the approach taken by FHW Capital was that it obviated the need for one or more public ratings of the underlying debt, streamlining the process and reducing costs. When the transaction reached financial close in mid-September, the all-in price for the circa £81m of debt raised equated to 231bps over the reference gilt.

There are plenty of challenges to introducing a capital markets solution to any PFI project and this is no less true of social housing. The Salford project involves the design and refurbishment of 1,270 existing housing units and their ongoing maintenance and lifecycle replacement over a 30-year concession length, together with associated housing management services, such as rent collection.

Despite the relatively straightforward nature of the refurbishment works, higher levels of construction security were required to provide the necessary contractor credit enhancement than might typically feature in a bank financed deal. However, this was offset by the margin savings that could be achieved as a result of the more robust security package.

Ultimately, the transaction demonstrated that institutional investors will accept construction risk as long as it has been the subject of proper due diligence and can be shown to have been appropriately mitigated. Similarly, other aspects of the Salford transaction moved away from sector based precedents towards an approach that more closely reflected precedents in those sectors that had previously succeeded in attracting capital markets financing.

However, the innovative nature of the enhancement structure meant that there were a number of departures from the approach typically taken on wrapped bonds. The structure also utilises an independent ‘managing agent’ responsible for administering the covenant package, taking routine decisions and providing regular reporting on the project’s performance to investors.

This role will be undertaken by FHW Capital and graduated intercreditor voting arrangements provide investors with the ability to participate directly in important decisions.

It’s been a busy third quarter, with both Salford and Leeds social housing PFI projects achieving successful bond financings. Where once the capital markets were the preserve of mega-PFI projects in sectors like health and transport, it seems bond financing has now gone mainstream and is likely to be a feature of future social housing projects.